One deal MBIA would rather forget

Commentary: Reinsurance helped company avoid loss

HerbGreenberg

SAN DIEGO (CBS.MW) -- MBIA, the country's biggest insurer of municipal bonds, took out special reinsurance in 1998 to avoid taking $170 million in losses after it knew the loss would occur.

The move, which some critics believe resembled a loan, helped management and other employees reap $36 million in bonuses that year.

While it was disclosed at the time, nobody raised much of a fuss.

This was, after all, pre-Enron, when income smoothing was as common as analysts doing double-duty as investment bankers.

But then, a year ago, AIG
AIG, -2.06%
got nailed for selling a type of so-called "retroactive" reinsurance -- also in 1998 -- to cell-phone distributor Brightpoint
CELL, +0.00%
A week ago AIG disclosed that the deal, a round-trip of money that helped Brightpoint avoid showing losses, is the focus of a federal probe.

Which gets us to MBIA
MBI, -1.90%
and its use of retroactive reinsurance. I originally wrote about this a year ago for my former employer, TheStreet.com, in a publication seen by an elite group of institutional investors who paid dearly to subscribe. It was a tale that needed to be told then, and in light of recent events, needs to be told again.

At the very least, what MBIA did was like buying insurance on your house after the fire and getting reimbursed for the damage only if you agree to use more than the amount you received to buy even more insurance in the future. This is something that's actually quite common in the insurance industry, where the goal is keeping insurers solvent. It's also well within the boundaries of accounting rules, with one caveat: to pass the sniff test, there has to be a benefice "transfer of risk" from the insured -- in this case MBIA -- to the insurers.

Was risk transferred?

In interviews a year ago and in recent days, senior MBIA officials insist there was and stress that's one big difference between MBIA's reinsurance and Brightpoint's. But risk transfer in the arcane world of reinsurance is subject to interpretation, especially when the reinsurance was bought after the loss.

Here's what happened: MBIA insured $256 million in bonds for the Allegheny Health, Education & Research Foundation. In 1998, after Allegheny Health declared bankruptcy, MBIA lined up $170 million of retroactive reinsurance with several different companies to cover expected losses. MBIA received $170 million in "reinsurance recoveries" later that year, helping MBIA avert what would have been its biggest loss ever; it would've also been the biggest loss for the financial guaranty industry. In a press release announcing the deal, MBIA said the cost of the reinsurance would have "a minimal impact" on earnings over the next few years. That's because MBIA put virtually no money up-front. Instead, in return for providing the insurance, the insurers were guaranteed future business from MBIA in excess of $170 million.

Scratch my back, I'll scratch yours

Nothing like you scratch my back, I'll scratch yours. The deal raised a few eyebrows in the credit-rating and financial communities, where such words as "clever" and "unusual" were used. But even that quickly died down. This, after all, was MBIA -- a company that prides itself on a "no loss" underwriting policy and a Triple-A credit rating. It's so intertwined with the financial markets that any hint of impropriety and a monstrous loss could have impaired its pristine credit rating, which is critical to providing insurance to municipalities. That, in turn, could have caused a domino falling trail of trouble.

That's why the issue of risk transfer is so critical. MBIA says proof risk was transferred is that the re-insurers agreed to insure future deals across a spectrum of credit qualities. What's more, MBIA stresses, the deal was given a stamp of approval by its auditors and insurance regulators -- and it was fully disclosed.

Sounds good on paper, but as the current insurance industry controversy suggests, approval by insurance regulators, who appear to be better at rubber stamping than regulating, doesn't necessarily mean anything. Neither does full disclosure. (As I like to say: Gives savvy investors more dots to connect.) And as I wrote a year ago, just because an arrangement was blessed by the auditors doesn't guarantee that it was in keeping with the sprit of reinsurance accounting rules, which are a classic shade of gray.

For example, the Financial Accounting Standards Board says any kind of reinsurance can't "directly or indirectly compensate" the insurer for losses. MBIA insists insurers weren't compensated, but instead were paid a premium "for the new risk they were assuming" on future coverage. But according to exhibits in the company's 1998 10-K, the initial premiums -- split among three re-insurers -- totaled just $3.85 million; that's paltry amount relative to the amount of insurance MBIA is believed to have agreed to buy in the future. While MBIA has never put a number on it, Moody's has said it "probably equals about one and a half times the amount of the loss that the reinsurers are assuming," or about $255 million.

A deal Houdini would've loved

The deal was so off-the-wall that an analyst at Fitch Investors Service at the time called it "the bond insurance equivalent of Houdini."

Without cash from the reinsurers, outgoing Chairman and CEO David Elliott wouldn't have been able to boast in his 1998 letter to shareholders about the year's "record profitability" or say: "And with $170 million of reinsurance, our loss reserves, our earnings and our Triple-A ratings were unaffected." Almost makes it sound as if the company had been smart enough to get regular reinsurance on the Allegheny Healthy debt before the loss occurred.

As it turns out, MBIA is believed to have bought regular reinsurance when the Allegheny Health policy was originally written for a fraction of the loss. Critics contend the retro reinsurance is more like a loan, with MBIA paying a small down payment. The insurers, in turn, get back an amount well in excess of their principal. (Almost like interest.)

Trying to smooth earnings

Former Morgan Stanley insurance analyst Alice Schroeder, in a report at the time, said MBIA's deal resembled "financial reinsurance," which occurs when "a reinsurer assumes risk, but the primary purpose of the transaction is financial, rather than risk transfer." She said such deals are usually done for the purpose of "earnings smoothing."

She added that "risk is not transferred unless reinsurance is purchased before the loss has occurred. By analogy, you cannot insure a burning building against fire. You can finance such a fire loss, but there is no risk to be transferred."

Again, MBIA insists risk was transferred -- and for that reason, the company says, the deal wasn't a loan. But on a conference call after the deal was done, in a response to a question about MBIA's "reinsurance scheme," Moody's said the policies directed to the reinsurers represented "low-risk portions of the portfolio" that in normal circumstances MBIA wouldn't insure. MBIA insists losses have occurred in those policies, but it hasn't quantified how those losses stack up with losses with policies covered by regular reinsurance other than to say the loss rates should be similar.

Whatever the case, in a later report Schroeder scolded the company, saying that the retro reinsurance "was a bad decision" the company was unlikely to repeat.

Will never happen again

The company agrees it won't happen again, saying in a written response to my questions that while the deal "made sense to the management team in place at the time, the subsequent management team would not use a similar arrangement given their different views on the use of reinsurance for these types of purposes and their different approach to the business."

By not taking a $170 loss, MBIA's earnings in 1998 were overstated by nearly 42 percent. Had the loss occurred, such things as return on equity, earnings per share and the company's "performance relative to peers" would've likely taken hits. Those are among the key elements used in determining company-wide bonuses. "In 1998," according to the proxy, "each of these performance goals were substantially met or exceeded," leading to the $36 million bonus payout. No winner was bigger than Elliott, the CEO at the time of the reinsurance deal, whose 1998 bonus lifted 66 percent $750,000 -- almost twice the increase of his bonus from the year before.

MBIA says compensation was not a factor in arranging the Allegheny Health reinsurance. It adds that the board's compensation committee considered the Allegheny Health loss "a negative factor" in determining the year's bonuses. How much lower would bonuses have been had the Allegheny Health loss not occurred? The company didn't say, other than to note that aside from the loss, "MBIA had a very strong year in 1998, including better financial performance in terms of new business production and earned premium growth" versus a year earlier. The company also made two big acquisitions.

Maybe, but it was also a year in which a loss was not a loss. Only in the insurance industry!

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